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P2P Lending: A User’s Guide

19 Apr 2017

Peer-to-Peer lending (or P2P Lending) is a super buzzwordy thing in today’s world. Things to look forward to in this post: why P2P lending might be better than your average bank, some technical details on how it actually works, and the potential problems down the road.

The Trouble With Banks

Banks are covered with regulation, and weighed down by their size. There are some good reasons for that. But let me start by saying that any retail bank had two original functions:

Accepting deposits of cash from depositors; and then

Lending a portion of that cash out to borrowers (offering credit).

But fairly quickly, that credit function begins to splinter off into particular areas of speciality:

Consumer Credit (for individuals)

Corporate Credit (for groups of individuals/companies)

Then it splinters further:

Consumer Credit

Short-term Credit (Credit Cards and Overdrafts)

Medium-term Credit (Vehicle Financing)

Long-term Credit (Mortgages)

Corporate Credit

Trade Credit (Overdrafts, Revolving Lines of Credit)

Project Financing (Leasing, Commercial Mortgages)

At this point, governments and central banks are generally confused by what the bank is doing, and where there’s risk for the depositors. So they insist on Risk Management Departments and Compliance. This, in turn, requires reform of the Treasury and IT Departments in order to produce the information that is needed to keep track of what is going on and where. The number of people involved in these tasks results in larger HR Departments; and the sheer volume of space required to maintain all of these employees demands cleaning staff and maintenance crews. Then you get Administrators and Client-Relations Personnel and Marketing departments and Expansion Committees and Internal Audit teams. And that’s only the Retail arm.

So before anyone has a moment to step back for breath, the banks are suddenly megalithic. And megaliths have to pay for themselves through fees and charges and interest differentials.

Getting back to basics

But perhaps we should take that moment and step back.

Because in the end, all that a retail bank really needs to be doing is putting spare money to use. It takes money from people that don’t need it right now (depositors), and gives it to the people that do (borrowers). It charges the borrowers for using the money, and then passes that fee along to the depositors/lenders, net of a little margin for their trouble.

The model may seem simple, but there are two main structural problems:

Timing (most depositors want to be able to draw their money whenever they feel like it – whereas most borrowers want to borrow for set durations of time); and

Defaulting borrowers (how do you know if a borrower is good for it?).

And dealing with those two problems is traditionally a question of scale:

When they are large, it is easier for banks to manage the liquidity gap caused by the different timing requirements (a broad depositor base is almost the same as having a large insurance pool – not everyone is going to need their money all at once); and

The banks manage their default risk by building up large departments devoted to credit checks, and equally large collection departments to deal with distressed borrowers in those situations where the credit checks fail.

But the world is changing

Today’s world is a little different to the one in which banks first came into being.

On the timing front, there are lots more tools for managing your money. People can generally decide what money they need to have access to, and what money they don’t. There are smartphone apps and computer spreadsheets to help. And most people do it all the time – putting aside money for savings, investments and so on.

And as for the default side of things, the credit information is all out there. There are credit bureaus that track an individual’s credit history. That history is a collation of mortgage repayments, bank debt and store credit. And there is also social media and the power of public review. Public reviews that people actually use.

So it’s quite possible that there’s room for disruption here: and to remove banks as the formal go-between. In theory, it’s quite possible for us to sort through the potential borrowers ourselves.

And if you think about it, we’re already in the practice of “offering credit” to people that we don’t know. For example, buying stuff on ebay. In that scenario, you’ve paid before you receive the good, making that in-between period an extension of credit to the seller. So when you buy something, isn’t the first place you look the seller’s rating?

Given that, it shouldn’t come as a surprise that P2P lending is on the rise. If you remove the middle man:

the depositor can earn a higher return than they would at a bank;

and borrowers could end up paying less than they would on credit-card debt and pay-day loans.

How P2P Lending Works

At the risk of repeating myself here, the basic idea behind social lending is simple:

There are depositor-lenders with money that they’d like to save in a place that offers a higher return than a fixed deposit;

There are borrowers that either would prefer to pay lower interest rates (than, say, the interest rates on credit cards and payday loans) or want their loans in increments (for example, small companies that are looking to expand but want a series of small loans rather than the large upfront one being offered by the bank).

These people need a marketplace in order to transact.

That marketplace is provided by the social-lending company, which invests its start-up capital in building a platform that is secure and user-friendly (the marketplace), and in gathering enough depositors and borrowers to make the whole thing flow smoothly (the market). The lending process runs via an auction, where depositors “bid” to lend money to borrowers.

In practice, if you wanted a loan, you would do the following:

You’d register with the social-lending platform (much like signing up for a facebook account – although you’d need to submit a bit more self-identification that just a verification email, because you’re basically opening an online bank account).

You fill in a loan application form, giving your background, how much money you want, for how long, the maximum interest rate you’d be willing to pay, and how long a period you’d like your “auction” to run for.

The platform will run a background credit check and then allocate you a credit score based on your credit history over the last three years.

The depositors can then bid to take up your loan (or a portion of it) during the course of your auction period. If you successfully raise the loan based on your parameters and the depositor-investor appetite for your interest, then money will be transferred from the depositors’ accounts on the platform into your online account. You can then on-transfer the loan money into your normal bank account.

The social lender makes no guarantees on repayment of loans – they are not a bank. Basically, the principle operates something like insurance: if there are plenty of depositors lending to multiple borrowers in small slices (they recommend that lenders give plenty of small loans rather than one or two big loans), then a single default will just lower your returns slightly.

At the same time, if a borrower does default, then the social lender will usually try and recover the loan through all the normal channels (debt-collectors, legal action, etc). And the borrower then gets kicked off the platform rather publicly.

In principle, this should work well. Borrowers have a clear incentive to develop good credit ratings by repaying their loans (because it’ll mean transparent access to lower rates and faster loan issues), and depositors get to make good (and low cost) returns for relatively low risk investments. The social lenders get to earn a fee. And the whole process is mostly unregulated, because it’s new and no one has gotten badly hurt yet.

The market is growing rapidly – according to some of the lending websites, at 105% per year. There are some fairly established P2P lenders (like Zopa in the UK), and even South Africa has its own established platform (Rainfin).

The Trouble With P2P Lending (and credit in general)

Here’s the problem: in general, many financial crises start with a great idea that spins rapidly out of control. And social lending is… a really great idea. It’s disruptive, and it forces the banks to re-look at their administrative size. It could drive up interest rates offered to savers (who have the option of taking their money elsewhere), and drive down interest rates for borrowers (who now have the option of obtaining their money elsewhere).

But we’re dealing with credit here. And credit… credit is really the art of money creation.

So maybe let me explain this:

Let’s assume that we live in a country in which there is only one company that everyone works for (the Super Market), and its also the company that everyone buys food and supplies from (it is, after all, the Super Market).

Everyone earns a salary of $10,000 per month, which they can either save or immediately spend at the Super Market, buying the food and supplies that they helped to produce.

Then a lender arrives on the scene, who says “let’s lend each other money”.

The people that were saving their money (let’s say they were keeping $5,000 per month in their mattresses) now give it to those people that want to spend it.

The people that were spending $5,000 per month are still spending their $5,000 per month.

The people that were spending their full $10,000 per month are now spending $15,000.

In terms of buying power, where before there was only $15,000 being spent, there is now $20,000 being spent. Meaning that there is more money chasing the same amount of goods (because nothing else has changed).

So the Super Market attempts to produce more to meet the demand, meaning higher salaries and bonuses (which the borrowers can use to repay the lenders).

And where production can’t be increased, prices start to creep up (inflation).

When the whole credit process is moving in a positive direction, it’s all good. Credit tends to magnify optimism by taking the optimism and turning it into low interest rates and easier access to money – which has a self-fulfilling aspect to it.

The Credit Boom/Bust Cycle

But credit also magnifies pessimism. Let’s say that something sparks off a run at the lender – maybe a large borrower gets out of control, and people start to panic that they’re not going to get paid back. What happens? Everything seizes up:

The lenders start demanding money back, so the borrowers have to cut their spending from $15,000 down to $5,000 per month (they lose the first $5,000 because the lenders are no longer lending, and the second $5,000 because they have to repay what they’ve already borrowed).

The lenders are still only spending $5,000 per month.

Where $20,000 was once being spent, there is now only $10,000 flowing around.

So the Super Market cuts production by half, fires people, and orchestrates pay cuts (making the problem worse).

Cue: Depression.

Credit is a key contributor to the boom and bust cycle of economies. People shift between greed and fear like sheep in a flock – and those emotions are amplified by the credit process.

What Reserve Banks and governments attempt to do is manage those emotions. They put in place deposit insurance schemes to keep depositors from worrying that their money is safe. They make banks keep reserves to try and assuage the fear that the bank might fail. And when there is a credit crunch, the Reserve Bank goes on quantitative easing sprees to try and make sure that the borrowers (the spenders) have money to continue spending and stimulating.

P2P lending is great while the industry is small. But what happens when it rides high on the wave of optimism, and becomes a significant component of credit in the economy? All it needs is one large P2P lender to get too greedy, and get a little lax with its credit-scoring. The default rates climb a little too high, and then the investor herd starts to slow lending. The existing borrowers then lose the incentive to repay their loans (why repay when you’re not going to get any more in future?).

And the economy seizes up.

And that’s not even taking into account the fact that P2P lending has no reserve system – meaning that the money creation is almost exponentially-related to the amount of time that social-lending rides that wave…